measuring a nation’s income

Measuring a Nation’s Income

Chapter 5

Learning ObjectivesLearning Objectives

Describe the origins of macroeconomics and the problems it deals with

Describe the long-term trends and short-terms fluctuations in economic growth, unemployment, inflation, and government and international deficits

Learning Objectives (con't.)Learning Objectives (con't.)

Explain why economic growth, unemployment, inflation, and deficits matter

Identify the macroeconomic policy challenges and describe the tools available for meeting them

Learning ObjectivesLearning Objectives

Distinguish between the stocks of capital and wealth and the flows of production, income, investment and saving

Explain why aggregate income, expenditure, and product are equal

Explain how GDP is measured

Learning ObjectivesLearning Objectives

Describe the origins of macroeconomics and the problems it deals with

Describe the long-term trends and short-terms fluctuations in economic growth, unemployment, inflation, and government and international deficits

Microeconomics

Microeconomics is the study of how individual households and firms make decisions and how they interact with one another in markets.

Macroeconomics

Macroeconomics is the study of the economy as a whole. Its goal is to explain the economic changes

that affect many households, firms, and markets at once.

Macroeconomics

Macroeconomics answers questions like the following: Why is average income high in some countries

and low in others? Why do prices rise rapidly in some time periods

while they are more stable in others? Why do production and employment expand in

some years and contract in others?

Origins and Issues of Origins and Issues of MacroeconomicsMacroeconomics

Modern macroeconomics emerged during the Great Depression.

People began to doubt the free market economy.

John Maynard Keynes, in 1936, published The General Theory of Employment, Interest, and Money.

Origins and Issues of Origins and Issues of MacroeconomicsMacroeconomics

Macroeconomic Problems

1) Economic Growth

2) Unemployment

3) Inflation

4) Deficits

Origins and Issues of Origins and Issues of MacroeconomicsMacroeconomics

Short-Term Versus Long-Term GoalsKeynes focused on the short-term primarily

• He felt the depression was caused by insufficient private spending

• Government should increase its spending

Origins and Issues of Origins and Issues of MacroeconomicsMacroeconomics

Short-Term Versus Long-Term GoalsLong-term consequences were virtually

disregarded• “In the long run, we’re all dead”

Origins and Issues of Origins and Issues of MacroeconomicsMacroeconomics

Short-Term Versus Long-Term GoalsToday, macroeconomics is concerned with:

• Long-term economic growth and inflation

• Short-term business fluctuations and unemployment

Origins and Issues of Origins and Issues of MacroeconomicsMacroeconomics

The Road AheadThe focus of macroeconomics has

shifted:• Depression• Inflation of the 1970’s• International economics of today

Economic Growth in theEconomic Growth in theUnited StatesUnited States

Fluctuations Around Potential GDPThe business cycle is the periodic but

irregular up-and-down movement in production.

Economic Growth in theEconomic Growth in theUnited StatesUnited States

Phases of the Business CycleRecession

• Period during which real GDP decreases for two successive quarters

Expansion• Period during which real GDP increases

Economic Growth in theEconomic Growth in theUnited StatesUnited States

Turning PointsPeak

• Expansion ends, recession begins

Trough• Recession ends, expansion begins

Long-Term Economic GrowthLong-Term Economic Growthin the United Statesin the United States

Economic Growth AroundEconomic Growth Aroundthe Worldthe World

Real GDP per personThe growth rate of real GDP divided by the

population is used to compare growth rates over time and across countries.

Benefits and Costs ofBenefits and Costs ofEconomic GrowthEconomic Growth

BenefitsExpanded production possibilities

• health care

• medical research

• space exploration

• roads

• environmental improvements (if resources are devoted to solving environmental problems)

Benefits and Costs ofBenefits and Costs ofEconomic GrowthEconomic Growth

Costs

1) Foregone consumption

2) Depletion of natural resources

3) Increased pollution

4) More frequent job and location changes

Macroeconomic Policy Macroeconomic Policy Challenges and ToolsChallenges and Tools

Policy Challenges

1) Boost economic growth

2) Stabilize the business cycle

3) Reduce unemployment

4) Keep inflation low

5) Reduce the government and international deficits

Macroeconomic Policy Macroeconomic Policy Challenges and ToolsChallenges and Tools

Policy Tools

1) Fiscal policy• Making changes in taxes and government

spending– Long term growth– Smooth the business cycle

Macroeconomic Policy Macroeconomic Policy Challenges and ToolsChallenges and Tools

Policy Tools

2) Monetary policy• Changing interest rates and the amount of money

in the economy– Control inflation– Smooth business cycle

The Economy’s Income and Expenditure

When judging whether the economy is doing well or poorly, it is natural to look at the total income that everyone in the economy is earning.

The Economy’s Income and Expenditure

For an economy as a whole, income must equal expenditure because: Every transaction has a buyer and a

seller. Every dollar of spending by some buyer

is a dollar of income for some seller.

Gross domestic product (GDP) is a measure of the income and expenditures of an economy.

It is the total market value of all final goods and services produced within a country in a given period of time.

Gross Domestic Product

The Circular-Flow Diagram

The equality of income and expenditure can be illustrated with the circular-flow diagram.

The Circular-Flow Diagram

Firms Households

Market for Factors

of Production

Market for Goods

and Services

SpendingRevenue

Wages, rent, and

profit

Income

Goods & Services

sold

Goods & Services bought

Labor, land, and capital

Inputs for production

The Measurement of GDP

GDP is the market value of all final goods and services

produced within a country in a given period of time.

The Measurement of GDP

Output is valued at market prices. It records only the value of final goods,

not intermediate goods (the value is counted only once).

It includes both tangible goods (food, clothing, cars) and intangible services (haircuts, housecleaning, doctor visits).

The Measurement of GDP

It includes goods and services currently produced, not transactions involving goods produced in the past.

It measures the value of production within the geographic confines of a country.

It measures the value of production that takes place within a specific interval of time, usually a year or a quarter (three months).

The Measurement of GDP

What Is Counted in GDP?

GDP includes all items produced in the economy and sold legally in markets.

What Is Not Counted in GDP?

GDP excludes most items that are produced and consumed at home and that never enter the marketplace.

It excludes items produced and sold illicitly, such as illegal drugs.

Other Measures of Income

Gross National Product (GNP) Net National Product (NNP) National Income Personal Income Disposable Personal Income

Gross National Product

Gross national product (GNP) is the total income earned by a nation’s permanent residents (called nationals).

It differs from GDP by including income that our citizens earn abroad and excluding income that foreigners earn here.

Net National Product (NNP)

Net National Product (NNP) is the total income of the nation’s residents (GNP) minus losses from depreciation.

Depreciation is the wear and tear on the economy’s stock of equipment and structures.

National Income

National Income is the total income earned by a nation’s residents in the production of goods and services.

It differs from NNP by excluding indirect business taxes (such as sales taxes) and including business subsidies.

Personal Income

Personal income is the income that households and noncorporate businesses receive.

Unlike national income, it excludes retained earnings, which is income that corporations have earned but have not paid out to their owners.

In addition, it includes household’s interest income and government transfers.

Disposable Personal Income

Disposable personal income is the income that household and noncorporate businesses have left after satisfying all their obligations to the government.

It equals personal income minus personal taxes and certain nontax payments.

The Components of GDP

GDP (Y ) is the sum of the following: Consumption (C) Investment (I) Government Purchases (G) Net Exports (NX)

Y = C + I + G + NX

The Components of GDP

Consumption (C): The spending by households on goods and

services, with the exception of purchases of new housing.

Investment (I): The spending on capital equipment,

inventories, and structures, including new housing.

Gross Domestic ProductGross Domestic Product

Gross InvestmentThe total amount spent on adding to the

stock of capital and on replacing depreciated capital

Net InvestmentThe amount spent on adding to the stock of

capital• Gross Investment minus Depreciation

Capital and InvestmentCapital and Investment

Initialcapital

The Components of GDP

Government Purchases (G): The spending on goods and services by local,

state, and federal governments. Does not include transfer payments because

they are not made in exchange for currently produced goods or services.

Net Exports (NX): Exports minus imports.

GDP and Its Components (1998)

Total(in billions of dollars)

Per Person(in dollars) % of Total

Gross domestic product, Y $8,511 $31,522 100 percent

Consumption, C 5,808 21,511 68

Investment, I 1,367 5,063 16

Government purchases, G 1,487 5,507 18

Net exports, NX -151 -559 -2

GDP: The Income ApproachGDP: The Income Approach

Compensation ofemployees 4,449 58.7

Net Interest 405 5.4

Rental Income 127 1.7

Corporate Profits 650 8.6

Proprietors’ income 518 6.8Indirect taxesless subsidies 569 7.5

Capital consumption(depreciation) 858 11.3

Gross domestic 7,576 100.0product

Amount in 1996 Percentage

Item (billions of dollars of GDP

GDP and Its Components (1998)

GDP and Its Components (1998)

Consumption 68 %

Investment16%

GDP and Its Components (1998)

Consumption 68 %

Consumption 68 %

Government Purchases

18%

GDP and Its Components (1998)

Investment16%

Net Exports -2 %

GDP and Its Components (1998)

Consumption 68 %

Investment16%

Government Purchases

18%

Aggregate Expenditure,Aggregate Expenditure,Output, and IncomeOutput, and Income

0

40

60

80

100P

erce

nta

ge o

f G

DP

Aggregateexpenditure

20

NX G

I

C

GDP

GDP

Depreciation

Indirect taxesless subsidiesProprietor’sincomesInterestProfitsRent

Wages and otherlabor income

Aggregateincome

Real versus Nominal GDP

Nominal GDP values the production of goods and services at current prices.

Real GDP values the production of goods and services at constant prices.

Real versus Nominal GDP

An accurate view of the economy requires adjusting nominal to real GDP by using the GDP deflator.

GDP Deflator

The GDP deflator measures the current level of prices relative to the level of prices in the base year.

It tells us the rise in nominal GDP that is attributable to a rise in prices rather than a rise in the quantities produced.

GDP Deflator

100GDP Real

GDP Nominal=deflator GDP

The GDP deflator is calculated as follows:

100X )deflator (GDP) GDP (Nominal

=GDP Real20xx

20xx20xx

Converting Nominal GDP to Real GDP

Nominal GDP is converted to real GDP as follows:

Real and Nominal GDP

YearPrice ofHot dogs

Quantity ofHot dogs

Price of Hamburgers

Quantity ofHamburgers

2001 $1 100 $2 50

2002 $2 150 $3 100

2003 $3 200 $4 150

Real and Nominal GDP

Calculating Nominal GDP:

2001 ($1 per hot dog x 100 hot dogs) + ($2 per hamburger x 50 hamburgers) = $200

2002 ($2 per hot dog x 150 hot dogs) + ($3 per hamburger x 100 hamburgers) = $600

2003 ($3 per hot dog x 200 hot dogs) + ($4 per hamburger x 150 hamburgers) = $1200

Real and Nominal GDP

Calculating Real GDP (base year 2001):

2001 ($1 per hot dog x 100 hot dogs) + ($2 per hamburger x 50 hamburgers) = $200

2002 ($1 per hot dog x 150 hot dogs) + ($2 per hamburger x 100 hamburgers) = $350

2003 ($1 per hot dog x 200 hot dogs) + ($2 per hamburger x 150 hamburgers) = $500

Real and Nominal GDP

Calculating the GDP Deflator:

2001 ($200/$200) x 100 = 100

2002 ($600/$350) x 100 = 171

2003 ($1200/$500) x 100 = 240

(Periods of falling real GDP)

Real GDP in the United States

1970 1975 1980 1985 1990 19953,000

4,000

5,000

6,000

7,000

Billions of 1992 Dollars

2000

8,000

GDP and Economic Well-Being

GDP is the best single measure of the economic well-being of a society.

GDP per person tells us the income and expenditure of the average person in the economy.

GDP and Economic Well-Being

Higher GDP per person indicates a higher standard of living.

GDP is not a perfect measure of the happiness or quality of life, however.

GDP and Economic Well-Being

Some things that contribute to well-being are not included in GDP. The value of leisure. The value of a clean environment. The value of almost all activity that takes place

outside of markets, such as the value of the time parents spend with their children and the value of volunteer work.

GDP, Life Expectancy, and Literacy

Country Real GDP perPerson (1997)

LifeExpectancy

AdultLiteracy

United States $29,010 77 years 99%

Japan 24,070 80 99

Germany 21,260 77 99

Mexico 8,370 72 90

Brazil 6,480 67 84

Russia 4,370 67 99

Indonesia 3,490 65 85

China 3,130 70 83

India 1,670 63 53

Pakistan 1,560 64 41

Bangladesh 1,050 58 39

Nigeria 920 50 59

Summary

Because every transaction has a buyer and a seller, the total expenditure in the economy must equal the total income in the economy.

Gross Domestic Product (GDP) measures an economy’s total expenditure on newly produced goods and services and the total income earned from the production of these goods and services.

Summary

GDP is the market value of all final goods and services produced within a country in a given period of time.

GDP is divided among four components of expenditure: consumption, investment, government purchases, and net exports.

Summary

Nominal GDP uses current prices to value the economy’s production. Real GDP uses constant base-year prices to value the economy’s production of goods and services.

The GDP deflator--calculated from the ratio of nominal to real GDP--measures the level of prices in the economy.

Summary

GDP is a good measure of economic well-being because people prefer higher to lower incomes.

It is not a perfect measure of well-being because some things, such as leisure time and a clean environment, aren’t measured by GDP.

Graphical Review

The Circular-Flow Diagram

Firms Households

Market for Factors

of Production

Market for Goods

and Services

SpendingRevenue

Wages, rent, and

profit

Income

Goods & Services

sold

Goods & Services bought

Labor, land, and capital

Inputs for production

GDP and Its Components (1998)

Net Exports -2 %

Consumption 68 %

Investment16%

Government Purchases

18%

Real GDP in the United States

(Periods of falling real GDP)

1970 1975 1980 1985 1990 19953,000

4,000

5,000

6,000

7,000

Billions of 1992 Dollars

2000

8,000